Good day, fellow Fools! We're continuing Break Down August, during which we're looking for our new buy. Yesterday, I concluded that Belgium-based speech product manufacturer Lernout & Hauspie (Nasdaq: LHSP) is the top dog and first mover in an important, emerging industry. Today I finish our Break Down of the company by matching it up against our other five Rule Breaker criteria. Is it something we may want to own?
Sustainable advantage gained through business momentum, patents, visionary leadership, and/or inept competition.
L&H has several competitive advantages. First, its business is strong. Revenue rose from just under $100 million in 1997 to $344 million in 1999. That number will grow significantly this year with the acquisitions of Dictaphone and Dragon Systems. The company has zealously undertaken acquisitions like these in recent years, and the growth has propelled a surge in the stock price, which in turn has facilitated acquisitions, making the company an even stronger player in the speech technology field.
Second, L&H has a large technological jump on its competition. The voice recognition and translation business is about data. It requires access to vast amounts of information about languages, accents and voices. Jo Lernout and Pol Hauspie started their voice technology business in 1987 and have been compiling data ever since. The company estimates that its archive of reported voice data is equivalent to the number of words that 35,000 people speak in the course of a year, and every new acquisition brings more data to the company.
Finally, L&H is the only company to participate in all four of the areas of speech recognition software as I discussed in the first part of this study. That combination gives it a unique and fortified position in the speech-recognition industry.
Good management and smart backing.
This is normally the space where we name the companies that have given money to our Rule-Breaker wannabe, list the former jobs of the CEO and the other executives in the company (assuring ourselves that their resume makes them good managers) and end with a blessing. There are other ways, however, to evaluate management.
Microsoft (Nasdaq: MSFT) took an 8% equity stake in L&H in 1997, intending to include voice recognition capabilities in future versions of its Windows operating system. In 1999, Intel (Nasdaq: INTC) invested $30 million in L&H securities, which are convertible into common stock. Intel has also agreed to develop e-commerce and telephony solutions using L&H's technology.
L&H's management, however, is more suspect. Its president and CEO, Gaston Bastiaens, held the same positions at Quarterdeck, a software utilities and Internet applications company, where he compiled a less-than-stellar track record. Starting in January 1995, Bastiaens expanded Quarterdeck's product portfolio, and in doing so led a profitable company into the red. He jumped ship in September 1996 after two successive quarters of losses. This portfolio thereafter shorted the leaderless company. It wasn't long before Quarterdeck became a penny stock and got bought out by Symantec (Nasdaq: SYMC).
Swelling accounts receivable
But that's the past. How can we evaluate management in the present? One way is by looking at how it manages its operating cycle. L&H isn't very impressive on this front, either. In the second quarter of this year, while sales grew 104%, accounts receivable swelled 128%. The company booked $154 million in revenue, but had $237 million in booked revenue as yet uncollected. Days sales outstanding (DSO) hit 138 days, 110 days minus the effect of Dragon and Dictaphone.
That means that, even excluding the new businesses, about a third of a year passes before L&H collects the money that it books as sales. Now, some businesses need more time to collect than others, so it's best not to condemn a company based solely on the raw DSO number. It may be that long DSOs are customary in the industry. I'm not happy to see high accounts receivable at L&H, however. The reason has to do with the scrutiny the company has recently received from the Wall Street Journal, Forbes and others for its unusual revenue stream.
The warning sign came from revenues booked in Singapore and Korea. In the first six months of last year, L&H reported that it earned about $36 million in Singapore and $1 million in Korea. In the first half of this year, the company reported $1 million in revenue from Singapore and $127 million from Korea. That's a big change on both fronts. How does business dry up so quickly in Singapore and grow so rapidly in Korea?
The company credits a recent acquisition of a Korean firm for getting its products to the Korean market. If that's the case, it was a great acquisition -- it cost $25 million with the potential for a further $25 million based on performance, and two quarters later has already yielded 2.5x its cost in revenue. Wow.
But what kind of revenue comes and goes so quickly? Software licensing revenue, that's what. L&H licenses its products primarily to telephony companies and can recognize all of that nonrefundable revenue at the beginning of the contract, so long as no change in the product is expected.
L&H has posted a sample list of its Korean customers on its web site. While the list contains some big names, like Daewoo Securities and Hyundai Securities, it is dominated by small companies and start-ups. Here's where the accounts receivable problem takes on added meaning. When a company books revenue from a Korean start-up that designs interactive quizzes, but doesn't collect that money promptly, there is a fair chance that it may not see the money it is owed. That reported revenue may never actually materialize.
Not enough evidence of good management
I have no idea, of course, about the size of particular contracts or how their payment is structured, but there is reason for concern here. In spite of a spate of investor lawsuits and questions in the media, L&H has not been forthcoming at all about the huge revenue fluctuations the company sees, its swelling accounts receivable, or the nature of its business in Korea. That's the final strike against management, in my book: I want my managers to communicate often and frankly with stockholders.
Therefore, in spite of L&H's huge revenue growth and apparently successful acquisition strategy and product expansion, I don't feel comfortable calling its management "good." There are too many questions in my mind.
Excellent past share appreciation, measured by relative strength of 90 or higher.
L&H has gained over 100% in the last year, but its relative strength recently fell below 90. It now rests near 79.
The greater the consumer brand, the better.
L&H doesn't have a widespread consumer brand yet, though it owns big names in its niche.
A significant portion of the financial media has called it overvalued.
I haven't found any articles calling L&H overvalued.
Though L&H did well on the first two criteria, it didn't do well on the last four. Especially when considering the questions about management, I don't believe that the company passes Rule-Breaker muster.
Foolish investors, however, don't need me to tell them that a company is or is not a Rule Breaker -- they can decide that for themselves. If you want to voice your opinion on L&H and read what others have to say, stop by the Rule Breaker Companies discussion board.
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Brian Lund, TMF Tardior to the sharpshooters in Ieper